Whats Wrong with European Banks?

The European governments have taken several steps to ensure that another economic crisis does not break out on the continent. Several European nations have been practicing austerity. As a result, there have been deep spending cuts and countries have run up fiscal deficits which are less than 3% of the GDP. The whole world has lauded the efforts taken by the government to bring the crisis under control. However, it would be incorrect to say that the European economy is still recession-proof.

The biggest threat to the European economy now comes from its unstable banking system. The entire banking system is more than 291% of the GDP. Hence, if this problem is allowed to grow unnoticed quietly, the results will be catastrophic for the entire European continent.

In this article, we will have a closer look at some of the reasons which have destabilized the European banking system.

Rising Costs of Compliance

It is ironical that measures which have been taken to ensure the stability of the banking system are amongst the prime factors that are causing its destabilization. A wide variety of compliance measures have been introduced in the European banking system after the 2008 crash. The purpose of these measures is to ensure that the banking system always stays in good health. However, the problem is that increased compliance also means increased compliance costs. Hence, the various forms of compliance that have been imposed by national as well as supra-national bodies in Europe are adding up to 4% of the total revenue of the banks. These costs are rising steadily and are expected to reach 10% of the total revenue. Such high compliance costs will make it difficult for the banks to sustain in the event of any external shock. Hence, they need to be rationalized as soon as possible.

Propping Up Profits

A significant portion of the money controlled by European banks has been lent out to national governments. European banks are the biggest holders of national bonds on the entire continent. The problem is that the value of these bonds seems to be artificially inflated. In the past few years, the European central bank has been rapidly increasing the money supply. Most of this newly created money has found its way into stocks, bonds, and other asset classes. Hence, the current value of the bonds seems to be inflated. As a result, the mark to market profits being recorded by the banks is also inflated. Hence, finally, the valuation of the banks which has been derived based on these profits is also inflated. Investors, therefore, need to have a harder look at the income statement and balance sheet to determine the strength of individual European banks. This will help them determine the odds of insolvency

Shortened Yield Curve

The zero interest rate policy followed by the European Central Bank is hurting the profitability of local banks. This is because banks make money by borrowing for the short term at low-interest rates and funding for the long-term at high-interest rates. However, now both the short and the long-term interest rates are very near to zero. Hence, there isnt profit to be earned in the form of net interest margin.

Increasing Insolvency Rates

The European Central Bank has kept the interest rate meager. The interest rate has almost stayed at 0% throughout the period. Hence, the number of businesses facing insolvency is abysmally low. Low-interest rates mean most borrowers can continue to make payments on their loans. However, as the Fed is aggressively increasing interest rates in America, the ECB is soon expected to follow suit. Also, the zero interest rate policy cannot continue for a long time. Hence, interest rates are bound to rise. However, rising interest rates would also mean increasing payments. This would lead to more insolvencies and add to the already high non-performing asset (NPA) rate in Europe. It needs to be noted that the current NPAs total up to more than 30% of the net-worth of all the European banks. This is the situation when the net worth has been exaggerated, and the NPAs have been subdued. Given a crisis situation, the European banks stand in a precarious situation and are likely to go underwater in absolutely no time.

The Market Already Knows

The shares of most European banks are trading well below their book value. On an average, the stock value is about 50% of the book value of the assets held by the bank. In theory, this would mean an arbitrage opportunity. Some investor would buy out the whole bank and then sell its liabilities piece by piece for a profit. However, that is not happening! This is because the investors already know that the banks' books are much worse than they look.

Also, it is a known fact that the banks in the European Union are intimately connected to the state. They are the biggest borrowers to the state. Ideally, the nations would come to the rescue of European banks. However, the nations are themselves in financial jeopardy. In fact, the sharp drop in the prices of sovereign bonds and the banks' colossal exposure to these bonds is what will ultimately lead to the downfall of most banks.

To sum it up, the European banks are in a precarious position due to a wide variety of reasons. These reasons need to be looked at carefully in order to avoid the repetition of 2008 like disaster.

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The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.

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